Some Thoughts on the Downside

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It's almost a clich� to tout the so-often quoted wisdom of "if you take care of the downside, the upside will take care of itself." But in the reality of the investing world, downside is still significantly and inappropriately weighted in most investors' investment processes. Giving less thought and attention to the downside than it deserves means botched margin of safety calculations. Over the years, I've gravitated toward putting more time on worst-case analysis in the investment process. I'd like to share a few thoughts on the subject.


The most important things, which are also related concepts, are predictability, circle of competency and time horizon.

Let's talk about time horizon first. I often hear people say the longer you hold a stock, the less likely you'll incur a loss. Of course this is an inadequate way of thinking. As Warren Buffett wisely puts it: Time is only a friend of a wonderful business but an enemy of a mediocre business.

Peeling the onion a little bit more, we can infer the next level of meaning, which may have more practical uses in terms of investment analysis: The worst case almost goes up every year for a great business but could go down, even substantially, as time goes by for a mediocre business.

For instance, we can comfortably say that in a normal interest rate environment, Coca-Cola (KO) at 15 times earnings is a pretty good guess of near-term worst case. But since the fundamental of Coca-Cola grows every year, the worst case also grows every year, which is an ideal situation.

The same logic can be applied to Berkshire (BRK-B). Book value grows every year and 1.1 times book is a very good worst-case multiple without recession. So Berkshire's worst case also grows every year roughly at the rate of book value growth.

But you can't say the same thing with JCPenney (JCP) or AK Steel (AKS). I don't have any issues with those two companies to be clear. The point is that both businesses have fundamentals that are either greatly challenged or more cyclical in nature or both, which makes it hard to forecast the projector of the business fundamentals and come up with a reasonable worst-case multiple. It's possible but harder.

Going back to the time horizon. If you have a holding period of 30 years and you own Coca-Cola, I think there's almost no way you can lose money. But if your holding period is three years and you pay 50 times earnings, you can easily lose money. Over a long enough period, time will smooth out the effect of multiple expansion or contraction, and if you own a great business, the mistake of overpaying can be alleviated by a large extent. At least the risk of permanent capital loss is very low. Someone did the calculation that, had one invested in American Express (AXP) the day before it crashed due to the salad oil scandal, his or her CAGR would be almost the same as Warren Buffett's CAGR.

The next issues with which we are faced are predictability and circle of competency. Sometimes the industry dynamic has changed so much that it's hard to assess what could happen if things get worse. The cell phone industry offered a great lesson.

For retail investors, very often the correct way of acting is to stay away from industries with rapidly changing dynamics because it's hard to know the future if you are not an industry insider. Even if you are an industry insider, you may overestimate your ability to see how the future will shake out. Case in point, Nokia (NOK) and Blackberry (BBRY). Boy, did they look cheap at some point, and executives from both companies derided the iPhone when Apple (AAPL) first released it. You can use whatever metrics be it P/E, P/B or P/S and come up with some sort of worst case for Nokia and Blackberry (back then it was still called Research in Motion), but I doubt anybody sees the degree of drop in earnings power and book value for both companies.

Sometimes an industry is straight up out of your circle of competency. Retail and energy are prime examples. Both industries are so dangerous because you often see dramatic drops in stock prices in a short period of time, which will appear cheap and naturally catch the eye of a value investor. Through some study of how the stocks have traded in the past, one may come up with some worst case analysis very easily.

I didn't invest in energy stock and still haven't, although it is becoming increasingly interesting in both the distressed debt market and equity market. I saw plenty of articles on the downside analysis of energy companies last year. When oil was dropped to $90, $75 or $70 was used as worst case. When oil went to $75, $60 became the new worst case and when oil dropped to $60, $45 became the worst case. At below $40 a barrel, I see plenty of $25 worst case oil argument. This is fascinating because it illustrates how easily you can make an argument without solid evidence backing it up. I talked to some friends in the industry and they thought $20 to $25 is the worst case, but they carefully walked me through why that is so. I wonder how many energy investors really speak to many industry insiders and walk through the worst case math.

An investor can also face an itchy problem - he may understand the industry and the business but the worst case multiple is difficult to assign because history doesn't repeat itself; it only rhymes. As interest rates change, inflation rates change, and the supply and demand change; what the near-term or medium-term worst case multiple is will not be clear. Further complicating the problem is that the industry may have changed as well. I think a great example today is media companies. Here we are faced with rapidly changing industry dynamics, rapidly changing consumer viewing habits, high leverage and unprecedented low interest rates in the U.S. What is the worst case multiple for Viacom (VIAB) or Fox (FOXA)? Ten times earnings? Four times EV/EBITDA? Six times Price/Free Cash Flow? It's hard; it's an art; yet it's extremely important.

Let us remind ourselves again that the shorter the investment horizon is, arguably the more important the near-term worst case is. The longer the investment horizon is, the less important the near-term worst case is. Buffett once said if you are right about the business, you'll make a lot of money. You also need to hold it for a very long term if you pay too much. Downside risk, even for a holding period of three to five years, is real. Paying as close to the worst case as possible can have a meaningful impact on the investment results. The biggest hurdle, in my opinion, is the deprival superreaction bias coupled with the contrast bias. I will try to devote another article in the future to my experiences alleviating the effects of those biases.

This article first appeared on GuruFocus.


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